Moving Averages
By Casey Murphy, ChartAdvisor.com
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Table of Contents
1) Moving Averages: Introduction
2) Moving Averages: What Are They?
3) Moving Averages: How To Use Them?
4) Moving Averages: Factors To Consider
5) Moving Averages: Strategies
6) Moving Averages: Different Flavors
7) Moving Averages: Conclusion
Introduction
Technical analysis has been around for decades and through the years, traders
have seen the invention of hundreds of indicators. While some technical
indicators are more popular than others, few have proved to be as objective,
reliable and useful as the moving average.
Moving averages come in various forms, but their underlying purpose remains
the same: to help technical traders track the trends of financial assets by
smoothing out the day-to-day price fluctuations, or noise.
By identifying trends, moving averages allow traders to make those trends work
in their favor and increase the number of winning trades. We hope that by the
end of this tutorial you will have a clear understanding of why moving averages
are important, how they are calculated and how you can incorporate them into
your trading strategies.
What Are They?
Among the most popular technical indicators, moving averages are used to
gauge the direction of the current trend. Every type of moving average
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(commonly written in this tutorial as MA) is a mathematical result that is
calculated by averaging a number of past data points. Once determined, the
resulting average is then plotted onto a chart in order to allow traders to look at
smoothed data rather than focusing on the day-to-day price fluctuations that are
inherent in all financial markets.
The simplest form of a moving average, appropriately known as a simple moving
average (SMA), is calculated by taking the arithmetic mean of a given set of
values. For example, to calculate a basic 10-day moving average you would add
up the closing prices from the past 10 days and then divide the result by 10. In
Figure 1, the sum of the prices for the past 10 days (110) is divided by the
number of days (10) to arrive at the 10-day average. If a trader wishes to see a
50-day average instead, the same type of calculation would be made, but it
would include the prices over the past 50 days. The resulting average below (11)
takes into account the past 10 data points in order to give traders an idea of how
an asset is priced relative to the past 10 days.
Figure 1
Perhaps you're wondering why technical traders call this tool a "moving" average
and not just a regular mean? The answer is that as new values become
available, the oldest data points must be dropped from the set and new data
points must come in to replace them. Thus, the data set is constantly "moving" to
account for new data as it becomes available. This method of calculation ensures
that only the current information is being accounted for. In Figure 2, once the new
value of 5 is added to the set, the red box (representing the past 10 data points)
moves to the right and the last value of 15 is dropped from the calculation.
Because the relatively small value of 5 replaces the high value of 15, you would
expect to see the average of the data set decrease, which it does, in this case
from 11 to 10.
Figure 2
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What Do Moving Averages Look Like?
Once the values of the MA have been calculated, they are plotted onto a chart
and then connected to create a moving average line. These curving lines are
common on the charts of technical traders, but how they are used can vary
drastically (more on this later). As you can see in Figure 3, it is possible to add
more than one moving average to any chart by adjusting the number of time
periods used in the calculation. These curving lines may seem distracting or
confusing at first, but you'll grow accustomed to them as time goes on. The red
line is simply the average price over the past 50 days, while the blue line is the
average price over the past 100 days.
Figure 3
Now that you understand what a moving average is and what it looks like, we'll
introduce a different type of moving average and examine how it differs from the
previously mentioned simple moving average.
The simple moving average is extremely popular among traders, but like all
technical indicators, it does have its critics. Many individuals argue that the
usefulness of the SMA is limited because each point in the data series is
weighted the same, regardless of where it occurs in the sequence. Critics argue
that the most recent data is more significant than the older data and should have
a greater influence on the final result. In response to this criticism, traders started
to give more weight to recent data, which has since led to the invention of various
types of new averages, the most popular of which is the exponential moving
average (EMA). (For further reading, see Basics Of Weighted Moving Averages
and What's the difference between an SMA and an EMA?)
Exponential Moving Average
The exponential moving average is a type of moving average that gives more
weight to recent prices in an attempt to make it more responsive to new
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information. Learning the somewhat complicated equation for calculating an EMA
may be unnecessary for many traders, since nearly all charting packages do the
calculations for you. However, for you math geeks out there, here is the EMA
equation:
Figure 4
When using the formula to calculate the first point of the EMA, you may notice
that there is no value available to use as the previous EMA. This small problem
can be solved by starting the calculation with a simple moving average and
continuing on with the above formula from there. We have provided you with
a sample spreadsheet that includes real-life examples of how to calculate both a
simple moving average and an exponential moving average.
The Difference Between the EMA and SMA
Now that you have a better understanding of how the SMA and the EMA are
calculated, let's take a look at how these averages differ. By looking at the
calculation of the EMA, you will notice that more emphasis is placed on the
recent data points, making it a type of weighted average. In Figure 5, the
numbers of time periods used in each average is identical (15), but the EMA
responds more quickly to the changing prices. Notice how the EMA has a higher
value when the price is rising, and falls faster than the SMA when the price is
declining. This responsiveness is the main reason why many traders prefer to
use the EMA over the SMA.
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Figure 5
What Do the Different Days Mean?
Moving averages are a totally customizable indicator, which means that the user
can freely choose whatever time frame they want when creating the average.
The most common time periods used in moving averages are 15, 20, 30, 50, 100
and 200 days. The shorter the time span used to create the average, the more
sensitive it will be to price changes. The longer the time span, the less sensitive,
or more smoothed out, the average will be. There is no "right" time frame to use
when setting up your moving averages. The best way to figure out which one
works best for you is to experiment with a number of different time periods until
you find one that fits your strategy.
How To Use Them
Some of the primary functions of a moving average are to identify trends and
reversals, measure the strength of an asset's momentum and determine potential
areas where an asset will find support or resistance. In this section we will point
out how different time periods can monitor momentum and how moving averages
can be beneficial in setting stop-losses. Furthermore, we will address some of
the capabilities and limitations of moving averages that one should consider
when using them as part of a trading routine.
Trend
Identifying trends is one of the key functions of moving averages, which are used
by most traders who seek to "make the trend their friend". Moving averages are
lagging indicators, which means that they do not predict new trends, but confirm
trends once they have been established. As you can see in Figure 1, a stock is
deemed to be in an uptrend when the price is above a moving average and the
average is sloping upward. Conversely, a trader will use a price below a
downward sloping average to confirm a downtrend. Many traders will only
consider holding a long position in an asset when the price is trading above a
moving average. This simple rule can help ensure that the trend works in the
traders' favor.
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Figure 1
Momentum
Many beginner traders ask how it is possible to measure momentum and how
moving averages can be used to tackle such a feat. The simple answer is to pay
close attention to the time periods used in creating the average, as each time
period can provide valuable insight into different types of momentum. In general,
short-term momentum can be gauged by looking at moving averages that focus
on time periods of 20 days or less. Looking at moving averages that are created
with a period of 20 to 100 days is generally regarded as a good measure of
medium-term momentum. Finally, any moving average that uses 100 days or
more in the calculation can be used as a measure of long-term momentum.
Common sense should tell you that a 15-day moving average is a more
appropriate measure of short-term momentum than a 200-day moving average.
One of the best methods to determine the strength and direction of an asset's
momentum is to place three moving averages onto a chart and then pay close
attention to how they stack up in relation to one another. The three moving
averages that are generally used have varying time frames in an attempt to
represent short-term, medium-term and long-term price movements. In Figure 2,
strong upward momentum is seen when shorter-term averages are located
above longer-term averages and the two averages are diverging. Conversely,
when the shorter-term averages are located below the longer-term averages, the
momentum is in the downward direction.
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Figure 2
Support
Another common use of moving averages is in determining potential price
supports. It does not take much experience in dealing with moving averages to
notice that the falling price of an asset will often stop and reverse direction at the
same level as an important average. For example, in Figure 3 you can see that
the 200-day moving average was able to prop up the price of the stock after it fell
from its high near $32. Many traders will anticipate a bounce off of major moving
averages and will use other technical indicators as confirmation of the expected
move.
Figure 3
Resistance
Once the price of an asset falls below an influential level of support, such as the
200-day moving average, it is not uncommon to see the average act as a strong
barrier that prevents investors from pushing the price back above that average.
As you can see from the chart below, this resistance is often used by traders as a
sign to take profits or to close out any existing long positions. Many short sellers
will also use these averages as entry points because the price often bounces off
the resistance and continues its move lower. If you are an investor who is holding
a long position in an asset that is trading below major moving averages, it may
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be in your best interest to watch these levels closely because they can greatly
affect the value of your investment.
Figure 4
Stop-Losses
The support and resistance characteristics of moving averages make them a
great tool for managing risk. The ability of moving averages to identify strategic
places to set stop-loss orders allows traders to cut off losing positions before they
can grow any larger. As you can see in Figure 5, traders who hold a long position
in a stock and set their stop-loss orders below influential averages can save
themselves a lot of money. Using moving averages to set stop-loss orders is key
to any successful trading strategy.
Figure 5
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Factors To Consider
Data Used in Calculation
Most moving averages take the closing prices of a given asset and factor them
into the calculation. We thought it would be important to note that this does not
always need to be the case. It is possible to calculate a moving average by using
the open, close, high, low or even the median. Even though there is little
difference between these calculations when plotted on a chart, the slight
difference could still impact your analysis.
Finding an Appropriate Time Periods
Because most MAs represent the average of all the applicable daily prices, it
should be noted that the time frame does not always need to be in days. Moving
averages can also be calculated using minutes, hours, weeks, months, quarters,
years etc. Why would a day trader care about how a 50-day moving average will
affect the price over the upcoming weeks? On the other hand, a day trader would
want to pay attention to a 50-minute average to get an idea of the relative cost of
the security compared to the past hour. Some traders may even use the average
price over the past three minutes to gauge an uptake in short-term momentum.
No Average is Foolproof
As you know, nothing in the financial markets is for certain - certainly not when it
comes to using technical indicators. If a stock bounced off the support of a major
average every time it came close, we would all be rich. One of the major
disadvantages of using moving averages is that they are relatively useless when
an asset is trending sideways, compared to the times when a strong trend is
present. As you can see in Figure 1, the price of an asset can pass through a
moving average many times when the trend is moving sideways, making it
difficult to decide how to trade. This chart is a good example of how the support
and resistance characteristics of moving averages are not always present.
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Figure 1
Responsiveness to Price Action
Traders who use moving averages in their trading will quickly admit that there is
a battle between trying to make a moving average responsive to changes in
trend while not allowing it to be so sensitive that it causes a trader to prematurely
enter or exit a position. Short-term moving averages can be useful in identifying
changing trends before a large move occurs, but the downside is that this
technique can also lead to being whipsawed in and out of a position because
these averages respond very quickly to changing prices. Because the quality of
the transaction signals can vary drastically depending on the time periods used in
the calculation, it is highly recommended to look at other technical indicators for
confirmation of any move predicted by a moving average. (For more on various
indicators, see Introduction To Technical Analysis.)
Beware of the Lag
Because moving averages are a lagging indicator, transaction signals will always
occur after the price has moved enough in one direction to cause the moving
average to respond. This lagging characteristic can often work against a trader
and cause him or her to enter into a position at the least opportune time. For
example, the only way for a short-term moving average to cross above a longterm moving average is for the price to have recently moved higher - many
traders will use this bullish crossover as a buy signal. One major problem that
often arises is that the price may have already experienced a large increase
before the transaction signal is presented.As you can see in Figure 2, the large
price gap creates a buy signal in late August, but this signal is too late because
the price has already moved up by more than 25% over the past 12 days and is
becoming exhausted. In this case, the lagging aspect of a moving average would
work against the trader and likely result in a losing trade. Check out the next
section of this tutorial to learn about trading strategies involving moving
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averages.
Figure 2
Strategies
Different investors use moving averages for different reasons. Some use them as
their primary analytical tool, while others simply use them as a confidence builder
to back up their investment decisions. In this section, we'll present a few different
types of strategies - incorporating them into your trading style is up to you!
Crossovers
A crossover is the most basic type of signal and is favored among many traders
because it removes all emotion. The most basic type of crossover is when the
price of an asset moves from one side of a moving average and closes on the
other. Price crossovers are used by traders to identify shifts in momentum and
can be used as a basic entry or exit strategy. As you can see in Figure 1, a cross
below a moving average can signal the beginning of a downtrend and would
likely be used by traders as a signal to close out any existing long positions.
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Conversely, a close above a moving average from below may suggest the
beginning of a new uptrend.
Figure 1
The second type of crossover occurs when a short-term average crosses through
a long-term average. This signal is used by traders to identify that momentum is
shifting in one direction and that a strong move is likely approaching. A buy
signal is generated when the short-term average crosses above the long-term
average, while a sell signal is triggered by a short-term average crossing below a
long-term average. As you can see from the chart below, this signal is very
objective, which is why it's so popular.
Figure 2
Triple Crossover and the Moving Average Ribbon
Additional moving averages may be added to the chart to increase the validity of
the signal. Many traders will place the five-, 10-, and 20-day moving averages
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onto a chart and wait until the five-day average crosses up through the others –
this is generally the primary buy sign. Waiting for the10-day average to cross
above the 20-day average is often used as confirmation, a tactic that often
reduces the number of false signals. Increasing the number of moving averages,
as seen in the triple crossover method, is one of the best ways to gauge the
strength of a trend and the likelihood that the trend will continue.
This begs the question: What would happen if you kept adding moving
averages? Some people argue that if one moving average is useful, then 10 or
more must be even better. This leads us to a technique known as the moving
average ribbon. As you can see from the chart below, many moving averages
are placed onto the same chart and are used to judge the strength of the current
trend. When all the moving averages are moving in the same direction, the trend
is said to be strong. Reversals are confirmed when the averages cross over and
head in the opposite direction.
Figure 3
Responsiveness to changing conditions is accounted for by the number of time
periods used in the moving averages. The shorter the time periods used in the
calculations, the more sensitive the average is to slight price changes. One of the
most common ribbons starts with a 50-day moving average and adds averages
in 10-day increments up to the final average of 200. This type of average is good
at identifying long-term trends/reversals.
Filters
A filter is any technique used in technical analysis to increase one's confidence
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about a certain trade. For example, many investors may choose to wait until a
security crosses above a moving average and is at least 10% above the average
before placing an order. This is an attempt to make sure the crossover is valid
and to reduce the number of false signals. The downside about relying on filters
too much is that some of the gain is given up and it could lead to feeling like
you've "missed the boat". These negative feelings will decrease over time as you
constantly adjust the criteria used for your filter. There are no set rules or things
to look out for when filtering; it's simply an additional tool that will allow you to
invest with confidence.
Moving Average Envelope
Another strategy that incorporates the use of moving averages is known as an
envelope. This strategy involves plotting two bands around a moving average,
staggered by a specific percentage rate. For example, in the chart below, a 5%
envelope is placed around a 25-day moving average. Traders will watch these
bands to see if they act as strong areas of support or resistance. Notice how the
move often reverses direction after approaching one of the levels. A price move
beyond the band can signal a period of exhaustion, and traders will watch for a
reversal toward the center average.
Figure 4
Different Flavors
Most of the methods in which moving averages are used in trading have been
addressed within this tutorial, but this tool has also been used in the development
of other indicators. In this section, we will give you a basic introduction to a
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couple of these indicators, but most will require further study if you want to
incorporate them into your strategy.
Moving Average Convergence Divergence (MACD)
One of the most popular technical indicators, the moving average convergence
divergence (MACD) is used by traders to monitor the relationship between two
moving averages. It is generally calculated by subtracting a 26-day exponential
moving average from a 12-day EMA. When the MACD has a positive value, the
short-term average is located above the long-term average. As mentioned
earlier, this stacking order of the averages is an indication of upward momentum.
A negative value occurs when the short-term average is below the long-term
average - a sign that the current momentum is in the downward direction. Many
traders will also watch for a move above or below the zero line because this
signals the position where the two averages are equal (crossover strategy
applies here). A move above zero would be used as a buy sign, while a cross
below zero can be used as a sell signal. (For more on this, read Moving Average
Convergence Divergence - Part 1 and Part 2.)
Signal/Trigger Line
Moving averages aren't limited to just stock prices; MAs can be created for any
form of data that changes frequently. It is even possible to take a moving
average of a technical indicator such as the MACD. For example, a nine-period
EMA of the MACD values is added to the chart in Figure 1 in an attempt to form
transaction signals. As you can see, buy signals are generated when the value of
the indicator crosses above the signal line (dotted line), while short signals are
generated from a cross below the signal line. It is important to note that
regardless of the indicator being used, a move beyond a signal line is interpreted
in the same manner; the only thing that varies is the number of time periods used
to create it.
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Figure 1
Bollinger Band
A Bollinger band technical indicator looks similar to the moving average
envelope, but differs in how the outer bands are created. The bands of this
indicator are generally placed two standard deviations away from a simple
moving average. In general, a move toward the upper band can often suggest
that the asset is becoming overbought, while a move close to the lower band can
suggest the asset is becoming oversold. Since standard deviation is used as a
statistical measure of volatility, this indicator adjusts itself to market conditions.
The tightening of the bands is often used by traders as an early indication that
overall volatility may be about to increase and that a trader may want to wait for a
sharp price move. (For further reading, check out The Basics Of Bollinger Bands
and Introduction To Technical Analysis.)
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Figure 2
Conclusion
In this tutorial, we've covered the basics of moving averages. Here's a brief
recap:



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Few technical indicators are as popular and widely followed as the moving
average.
Moving averages come in various forms, but their underlying purpose
remains the same: to help technical traders track the trend of financial
assets by smoothing out the day-to-day price fluctuations, or noise.
The simplest form of a moving average is appropriately known as a simple
moving average (SMA). It is calculated by taking the arithmetic mean of a
given set of values.
The exponential moving average (EMA) assigns a weighting to recent
data because many traders regard this as the major downfall of the SMA.
Some of the primary roles of a moving average include identifying trends
and reversals, measuring the strength of an asset's momentum and
determining potential areas where an asset will find support or resistance.
A moving average can be a great risk management tool because of its
ability to identify strategic areas to stop losses.
Using moving averages can be very ineffective during periods where the
asset is trending sideways.
There are many different strategies involving moving averages. The most
popular is the moving average crossover.
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

Moving averages are used in the creation of a number of other very
popular technical indicators such as the moving average convergence
divergence (MACD) or Bollinger bands.
Moving averages won't solve all your investing problems. However, when
used judiciously, they can be valuable tools in planning your trading
strategy.
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